Private Currency and the Gold Standard

What is the feasibility of private currency, and how does the gold standard relate to this?

Money was not originally a creation of the state. It arose out of the market as a result of the difficulties of barter (or direct exchange). Imagine that an individual desires what another possesses, but that other is not interested in what the first individual has for sale. Or imagine that these two individuals would like to trade with each other, but one of the two commodities cannot be divided into portions that would reflect the agreed-upon terms of trade. In either case, one or both of the potential traders would be left frustrated and unable to consummate a desired transaction.

We could then imagine that a frustrated trader might search for ways to attain his desired end through a more indirect route. He might first trade the commodity in his possession for another good for which he has no use. But if he believes that he can turn around and resell this commodity for what he actually wants to purchase, he is then using this other commodity as a medium of exchange. He trades commodity "A" for commodity "B," and then trades commodity "B" for commodity "C." Commodity "B" has served as a medium of exchange.

Money developed out of such patterns of indirect exchange. Participants in the circles of exchange discovered that there were some commodities possessing qualities that made them easier to use to get things they wanted. The qualities economists have most frequently pointed to in this regard are: 1) a relatively high demand by a wide circle of people; 2) ease of divisibility; 3) easily transported; 4) fairly long durability; and 5) relatively limited in supply and not easily reproduced.

The commodities that were recognized as having the greatest combination of these attributes tended to become the most widely used and generally accepted media of exchange--the money-goods. Historically, the commodities most frequently used for this purpose have been gold and silver.

Money's value, historically, began with its value as an ordinary commodity. Indeed, it was its market value as a commodity with the attributes listed above that made it attractive to use as a medium of exchange. But now traders in the market started to demand this commodity not only for its own direct or consumer uses, but as an object of trade as well. It now has two components to its demand: its demand as a consumer item and its demand as medium of exchange. This made its value increase. Over time it can happen that the demand for it as an ordinary consumer item decreases or even disappears completely. Then its demand and its value to traders in the market would be solely in its capacity as a medium of exchange.

In either case, the value of money on the market is determined by the forces of supply and demand, as with any other good. Individuals have goods they are willing to sell to acquire money and they have sums of money earned from previous sales of goods which they may be willing to trade away to buy other things they want to purchase. The demand for money is represented by the supply of goods offered for money; and the demand for goods is represented by the supply of money offered for them.

In the market place, traders agree upon how many units of money will be traded for one newspaper, or one box of breakfast cereal, or one ticket to a rock concert. The set of exchange ratios between money and all the other goods on the market is, at any moment in time, the purchasing power or value of money.

And like any other commodity, money's value or purchasing power can change due to a change in its supply or demand conditions. An increase in the supply of money (other things left unchanged) will tend to lower its purchasing power; the prices of goods expressed in terms of money will rise. Or the demand for money could increase (people may wish to offer more goods on the market to acquire more money from sales; or they may want to hold on to a greater amount of money earned in the past as a cash balance, and they would do so by cutting back on their purchases of goods on the market); this would raise the purchasing power of money, with the prices of goods expressed in terms of money decreasing.

The history of banking is long and complex, often differing in important ways in different countries and at different times. But in general terms banks began as depositories for storing gold and silver. The depositors were issued claims to the sums they had left "on deposit." Over time, as the depository institutions gained recognition and reputation within a geographical area, the claims issued to sums of gold and silver began to be accepted in transactions in place of gold and silver. The claims or "notes" came to be viewed in trade as "good as gold." These claims became "money substitutes" for as long as the participants within a circle of exchange had confidence that the depository institutions could be depended upon to redeem these claims or notes "on demand."

These institutions also came to take on the role of financial intermediaries. They would use money left on deposit to extend loans to others in the community. There soon developed what today the textbooks call "fractional reserve banking." The financial intermediaries--these emerging banks--discovered that on average during any period of time depositors only demanded a fraction of the actual gold or silver on deposit. They could issue a second note or claim in the form of a loan to the same gold against which a depositor had a note or claim; and both notes could circulate and be accepted as money-substitutes in market transactions simultaneously.

As long as the banks acted conservatively and did not issue too many of these additional note-claims to a given amount of gold or silver in their vaults, there was not a problem. But if depositors became suspicious of the bank's ability to meet all of its liabilities "on demand" or if merchants began to doubt the soundness of the notes and refused to accept them (or only at a discount off their face value), there could be a "run on the bank."

The market, however, developed its one "checks and balances" to keep banks from over-issuing their notes and risking a panic and financial ruin. First, the fact that notes were payable in gold or silver on demand meant that the banks had direct feed back from their depositors every day to determine what percentage of the gold or silver on deposit was claimed for redemption on average each day, or week, or month. Second, banks developed the "clearing-house" mechanism. On a regular basis banks would transfer among themselves notes or checks they had received from their depositors, but which were issued by another bank. They would then determine the net amounts the banks owed each other, and gold and silver would then be transferred from on banking institution to another. This served as a second feedback mechanism to inform banks whether the amount of notes they issued was so far in excess that they were threatened with losing their gold and silver reserves to other banks.

The banking system was never allowed to fully develop or mature along free, private competitive lines. From the beginning of recorded history, government’s have appreciated the advantage to itself from controlling the issuing of money, whether in coined, paper or, now, electronic form. It could debase the currency and during the inflationary process draw goods, resources and wealth towards itself.

In the 19th century, this developed into Central Banking, under which either the government directly or its appointed institutional agent was given monopoly authority to control the quantity and value of money in the economy. The 19th century was also the zenith of Classical Liberalism, with its emphasis on individual liberty, free markets, free trade and "sound money." Sound money was considered a gold or silver backed currency, with the government expected to see to it that the all notes issued by banks would be paid on demand, and to see that any note issued had to be backed by a fixed amount of gold (in England, this was known as Peel's Bank Act of 1844).

There were omissions in this system (even with its intention of preventing inflation or government abuse). For example, checks payable on demand were not required to have the same one-to-one gold backing. For this reason and other political factors, the system (neither in England nor the rest of the "civilized world") in the 19th century did not work smoothly or perfectly. Nonetheless, by the end of the 19th century, all of the major countries of the Europe and North America were on gold standards.

In the 20th century, however, the collectivist "demons" were set lose. This resulted in a growing disregard for individual liberty, disrespect for contract and property rights and a growing desire by government to have a way to use the "printing press" for various economic, political and military goals. In the First World War, all the countries at war (except for the U.S.) went off the gold standard and governments printed tidal waves of paper money to pay for war expenditures. Even after the war, the inflation’s continued in several countries, especially in Germany, Austria and Russia. Their economies were nearly destroyed in the process.

In the 1920s, there were half-hearted attempts to return to a gold standard. But the political currents were not what they had been in the 19th century. After mismanagement of the monetary system by the Federal Reserve System in the 1920s resulted in the Great Depression, all the leading countries of the world "went off gold." They have remained off gold ever since.

Since the 1930s the world has operated with government controlled and mismanaged paper monies. It has caused roller-coasters of inflation and recession. There is no reason to think that if governments continue to monopolistically control money this will be any different in the future. The solution is ending central banking and allowing the market to replace it with free, competitive banking on the basis of a market-chosen money. Would it be perfect? No, there are no perfect institutions in a world of imperfect men. But there is no reason to believe that it would be worse than the inflations and depressions and recessions caused by government in our times. Indeed, it would be much better.

Kevin Dowd, "Private Money: The Path to Monetary Stability" (1988)

Kevin Dowd, "The State and the Monetary System" (1989)

Kevin Dowd, "Laissez-Faire Banking" (1993)

Kevin Dowd, ed., "The Experience of Free Banking" 1992)

Richard M. Ebeling, "Ludwig von Mises and the Gold Standard" in

"The Gold Standard: An Austrian Perspective," ed. by Lew Rockwell (1992)

Friedrich A. Hayek, "The Denationalization of Money" (1978)

Steven Horwitz, "Monetary Evolution, Free Banking and Economic Order" (1992)

Ludwig von Mises, "The Theory of Money and Credit" (1953)

Ludwig von Mises, "Monetary Stabilization and Cyclical Policy" [1928] in "On the Manipulation of Money and Credit" (1978) pp.138-140

Ludwig von Mises, "Human Action" (3rd revised ed. 1966) pp. 440-448

Murray N. Rothbard, "The Case for a 100 Percent Gold Dollar" (1991)

George A. Selgin, "The Theory of Free Banking: Money Supply Under Competitive Note Issue" (1988)

Hans Sennholz, "Money and Freedom" (1985)

Mark Skousen, "Economics of a Pure Gold Standard" (1988)

Vera C. Smith, "The Rationale of Central Banking and the Free Banking Alternative" (1990)

Lawrence H. White, "Free Banking in great Britain: Theory, Experience, and Debate, 1800-1845" (1984)

Lawrence H. White, "Competition and Currency: Essays on Free Banking and Money" (1989)